Near 52-Week Lows And Still Overvalued: Skip Hormel

It's been three years since my last article on Hormel (NYSE:HRL). Much has changed over that time frame, and I believe it worthwhile to follow the same format with this article as I did in the prior: conduct a valuation analysis using several different strategies. The exact numbers are different, but my conclusion is much the same: Hormel is still overvalued in spite of the precipitous drop on the back of disappointed results for their 2023 fiscal Q1 and an equally disappointing outlook for the coming year. Short term issues with inventory and pricing may alleviate, but I believe HRL has nonetheless entered a period of slower growth that will affect their ability to grow the dividend or maintain historic P/E ratios. Do not buy Hormel, and beware of more downside if you are already an owner.

DCF Analysis

My approach to DCF analysis with Hormel was to determine what kind of cash flow they would have to produce in order to be worth what they are currently trading for on open markets. In other words, instead of making best estimates for their ability to produce cash in the future and deriving an intrinsic value from that, I start with how the market is currently valuing them and then fiddle with the inputs until the intrinsic value number matches the market price, or thereabouts. This allows me to understand what market participants are expecting the company to achieve cash flow wise in order to price them thusly. While a less common approach, formally called a reverse engineered DCF analysis, I believe this technique offers considerable insight. Here is a spreadsheet of what I came up with:

As for a verbal explanation of the above numbers, here is what HRL would have to do in order to be worth ~$40 a share:

- Revenue growth must accelerate from 3% this year at the high end (management's guidance), to 6% next year, and then 10% for each of the three years after that. For context, HRL has grown revenue at a compounded annual rate of ~6% over the past 5 years. Given that larger numbers are hard to compound at high rates, for them to hit 10% revenue growth three years in a row feels far-fetched.

- Cash from operations margin coming in at 10% this year, 12% next, up to 14% for both years 2027 and 2028. For context, their best year on record was in 2018 at 13%. Their ten-year average cash margin is just under 10%. Last year it was less than 8%, and there are expectations for more margin pressure this year (which I will discuss later). Getting up to 14% for two years is a tall order.

- Terminal value of 3% growth in perpetuity. While 3% feels small, sustaining 3% for the rest of forever is highly improbable. Especially for a rather large company like Hormel. For mature stage companies, many analysts use 2% as a terminal value.

- I kept CAPEX level with what they typically have spent annually as a percent of sales in order to maintain their operations.

- My discount rate is 10%. I use this value because I assume most investors hope to at least match the long-term annual return of the stock market, which is around 10%. Pegging the required rate of return at that level is reasonable.

These are some outstanding results. And at least as far is cash flow is concerned, this is one example of the results HRL would have to achieve in order for the present value of all future cash flows to equal $40 on a per share basis. I would wager that this level of business performance is nigh impossible. But not everyone values companies on the basis of their cash generation potential. So let's move on to some other common valuation methods.

Dividend Growth

It is very common to value companies based on their dividend paying potential. Dividend growth investing is perennially popular. And it makes logical sense: a company's stock is worth the present value of all future dividend payments. HRL has been a dividend growth machine, even earning the coveted dividend king status, where they have grown their dividend every year for more than 50 years. So what would their dividend growth have to look like moving forward in order to justify a $40 share price? We can algebraically back into this number similar to how the reverse engineered DCF analysis was conducted, though I will be using the Gordon Growth Model, a variant of the dividend discount model. Here is that formula, typically solved for "P" but we are going to solve for "g":

Plugging in the data:

P = $40

D1 = $1.16, assuming that next year's dividend will grow by 6%, identical to the growth from last year.

g = the variable for which we are solving

r = 10%, my assumed required rate of return.

These numbers result in a required dividend growth rate of 7% for the rest of forever.

While they have bested that growth during much of their history, the pace of dividend growth has slowed in recent years, and that of necessity as their EPS growth has slowed and the dividend payout ratio has thusly been increasing, a bad omen for the pace of future dividend increases:

As management has guided to EPS of $1.70-$1.82 this year, if they come in at the low end the payout ratio will rise to 64% of earnings.

For those with a 10% required rate of return hurdle and who have conviction that HRL can increase their dividend by 7% annually for the rest of forever (necessitating a commensurate rise in EPS), then today HRL is fairly valued. For anyone who has doubts about that 7% number OR who has a higher required rate of return, then HRL should be avoided.

Inventory and Inflation

Hormel finds themselves in quite a predicament currently. They mismanaged production such that they now find themselves with a glut of finished goods that aren't selling. Simultaneously, they are facing inflationary pressures that they are attempting to counter-act with price increases. But obviously, things might get harder to sell if consumers have to pay more for them. All of this is exacerbated by the fact that HRL deals exclusively in perishables. They can't just hold onto stuff forever. Now, of course HRL management is going to be strategic about what items to increase prices on and which items to discount to try and normalize the situation. But that is not an easy task with all the variables in play.

When taken as a percent of sales over the following year, inventories have usually been in the 10%-11% range going back to 2013. They currently sit at 14%, a considerable increase. This issue came up in the prepared remarks from the most recent conference call:

Since the fall, we have been operating with elevated inventories due to our efforts to increase production, optimize plant performance and return fill rates to historical levels. We expected this inventory to clear during the normal course of business. This has not happened. And in fact, we have seen inventories continue to grow in a number of areas. This has resulted in inefficiencies across the supply chain and higher operating costs.

When pressed for more details during the Q&A sessions, they explained further:

... after almost three years of chasing unprecedented demand, our ability to supply our customers, consumers and operators caught up to and in some cases began to exceed demand and we needed to react sooner. Rectifying the inefficiencies caused by elevated inventory levels is the top priority in the company.

We do have elevated inventories of ribs. We have some elevated inventories of complete bacon bits....... (and) other perishable refrigerated items. We're not trying to pin this on any one item or one category. It is broad-based.

And here are some relevant comments made about inflation:

... we continue to operate in a volatile, complex and high-cost environment and cost pressures remain high. Our retail businesses, especially in the center store, continue to be disproportionately impacted by high inflationary pressures and the pricing actions we have taken over the last 18 months still lag inflation.

To help mitigate some of this pressure, we have announced additional inflationary justified pricing actions in certain retail categories effective late in the second quarter.

Bloated inventory, high expenses, and pricing problems are combining to form a considerable storm. While I am not predicting anything, it would not be surprising to see inventory write-downs in the near term. While these issues are solvable and don't necessarily pose any long-term threat to the business model, it does mean that 2023 might be a really bad year for HRL.

Conclusion

Between the short-term issues with inventory and pricing and the long-term issue of slower growth that can't sustain a high multiple, I anticipate HRL seriously under-performing the market averages for some time. Their P/E ratio has long been higher than the S&P, a situation that I don't believe can persist. This is to say nothing of matters that were beyond the scope of this article, avian flu being a big one that is hurting their turkey business, and then the issue of their Planter's nuts acquisition not having the start to the year they had hoped. Issues for another day and another article, perhaps.

Stocks that grow alongside GDP are typically worthy of a 15-18 multiple. I expect HRL to moderately exceed GDP growth for the next 5-10 years after a rough 2023, and a P/E of perhaps 20 would be appropriate. Based on TTM earnings of $1.78, a fair value stock price would be $35.60. Management's projection for earnings in 2023 are $1.70-$1.82, meaning a forward fair value stock price at a multiple of 20 would be between $34 and $36.40. Even in the best-case scenario, HRL stock is still overvalued. As a value investor, I look for a margin of safety before buying a stock. I would be interested in HRL and revisit my analysis at ~$30 a share, a long way down from here. Bulls beware.